Tuesday, May 13, 2014

Ricardian Equivalence with Astrology

I recently discussed recently discussed (again) whether it is reasonable to assume (just as a rough first approximation) that people have rational expectations. I considered the argument that a temporary balanced budget spending increase causes increased demand, because consumers rationally expect that tax increase to be temporary. Is unreasonable to expect people to assume it is permanent and then be surprised when it is reversed ?

I think it is unreasonable to expect people to be surprised. Since the overwhelming majority of people in the USA did not notice the 2009 tax cuts in the ARRA, I would guess that people wouldn't note the tax cuts and therefore wouldn't be surprised.

I am back to be rude again. One of the most idiotic of all ideas in human history is the idea that there is Ricardian equivalence. Extraordinarily, this implication of economic theory was so absurd that Ricardo himself recognised it had no relevance to reality.

However, it has become conventional to use models with Ricardian equivalence (even Krugman does this while stressing that he doesn't believe in Ricardian equivalence). it is even common to assert that the permanent income hypothesis which implies Ricardian equivalence is an improvement over earlier models of consumption which had the minor advantage of actually fitting the data.

Ricardian equivalence requires consumers to know what share of the national debt will be repaid by themselves and their heirs. It also requires the assumption that people reproduce asexually. A much simpler requirement is for people to know how big the national debt is. It is even simpler for people to know the current year's budget deficit (because it is publicized much more often). It is vastly immensely simpler for people to know the signn of the change of the budget deficit from one year to then next when that change is extraordinarily huge.

In the past years the US Federal budget deficit has declined at an extraordinarily rapid rate. Steve Benen notes
"It was just last year when an independent national poll asked Americans whether they thought the deficit was increasing, decreasing, or staying about the same. Only 6 percent of the country recognized reality. That’s not a typo; it was just 6 percent."

It seems most US adults are rather ignorant. But they are not insane or delusional. Therefore I am confident that they don't believe in Ricardian equivalence.

[rudeness deleted].
Of course the economists who consider rational expectations a good approximation know perfectly well that the vast majority of people are clueless about public budgets. I do not understand how they manage the cognitive dissonance.